The Employee Ownership Update

Corey Rosen

July 15, 2004

Tax Bill Would Help S Corporation ESOPs

Both the American Jobs Creation Act of 2004 (H.R. 4520) and the Jumpstart Our Business Strength Act (S. 1637, and something of a stretch of a title even for the acronym-obsessed denizens of D.C.) would allow S corporation ESOPs to use distributions paid on both allocated and unallocated stock in an ESOP to repay an ESOP loan. Current regulations allow only distributions on unallocated shares to be used. Most ESOP experts see this as a reasonable literal interpretation of the law but argue that it was simply drafting oversight that failed to make treatment of dividends and distributions in C and S corporations parallel for this purpose.

The two tax bills easily passed both houses of Congress, but the Senate bill is about seven times as long, and both bills contain what many critics, left and right, have called one of the worst cases of logrolling in years. The basic purpose of the bills was to amend the treatment of U.S. corporate income earned overseas. Both also reduce top corporate tax rates, either directly (as in the House bill, from 35% to 32%) or indirectly (the Senate bill does much the same thing through tax deductions). But both bills, especially in the Senate, served as magnets for every pet tax incentive members always wanted. In theory, the revenue losses were to be offset by other changes (see below, for instance), but now the bill will be quite costly. The bill is supposed to be headed to a conference committee, but many observers now think it may never get passed this Congress, meaning tax reformers would have to start off again next year.

Pending Tax Bills Would Restrict Tax Options on Deferred Compensation

The two tax bills described above also both contain significant new restrictions on the tax treatment of all kinds of deferred compensation, including stock-based compensation. Currently, employees can defer paying taxes on a vested stock award or a stock-equivalent award (such as a stock appreciation right) by agreeing in advance to defer receipt of the benefit after it is vested. This benefit generally is not used in conjunction with stock options, although it could be (it would make sense primarily with nonqualified options, although the financial virtues of using it with options is arguable). The Senate bill would affect stock options, restricted stock, phantom stock, stock appreciation rights, and similar plans, but the House bill excludes stock options and restricted stock. Under current rules, employees can elect to defer the receipt of deferred compensation in advance of full vesting, but it is not clear from regulations or rulings just how far in advance this has to occur. Some experts say six months, others a year, but there is no consensus. Under both bills, the deferral would have to take place at least 12 months before the benefit becomes vested, and that election must be no later than the calendar year prior to the year in which the compensation is earned or, if shorter, within 30 days after starting participation in the plan. So if an employee will be fully vested in 2008, the election would have to be in 2006. Payment could not be made until after separation from service (or six months after that for certain officers of the company), except in specified circumstances, including death, disability, mergers, and emergencies.

Stock Plan Audits More Likely

An IRS pilot program surveying employer compliance indicates that stock options and executive equity compensation are likely to be high up on future IRS audit target lists. Among the issues the IRS intends to focus on are: whether requirements for incentive stock options are being met; whether companies are avoiding Section 162(m) rules for executive compensation by resetting performance targets so that, in effect, the awards are almost guaranteed; and whether transfers of options to family limited partnerships are being used to avoid taxes.

Mellon Study Shows Decline in High-Tech Options

A new survey of 150 high-technology companies from Mellon Financial Corporation's Human Resources & Investor Solutions group shows that the "burn rate" for options in these companies declined by 30% over 2003, and the overall use of options declined by 15% to 20%. Burn rate refers to the percentage of a company's shares that options issued make up in a year. While options use declined, restricted stock use increased and became more common at more employee levels. On a global scale, multinational companies are tending to localize their plans rather than follow a single corporate template. More companies are also being more selective in their granting procedures. While high-tech companies continue to make most or all employees eligible for options, a larger percentage is basing actual allocation on performance criteria, meaning not everyone will actually get options.

The study, "Equity Practices Survey for the High Technology Industries," is based on a Mellon survey of both client and non-client companies who pay to take the survey. The results are available only to those taking the survey.